Tuesday, July 23, 2013

Is the interest rate on reserves holding the economy back?

The link between bond purchases and the money stock depends on the role of commercial banks’ “excess reserves.” When the Fed buys Treasury bonds or other assets like mortgage-backed securities, it creates “reserves” for the commercial banks, which the banks deposit at the Fed itself...

The link between Fed bond purchases and the subsequent growth of the money stock changed after 2008, because the Fed began to pay interest on excess reserves. The interest rate on these totally safe and liquid deposits induced the banks to maintain excess reserves at the Fed instead of lending and creating deposits to absorb the increased reserves, as they would have done before 2008.

As a result, the volume of excess reserves held at the Fed increased dramatically from less than $2 billion in 2008 to $1.8 trillion now. But the new Fed policy of paying interest on excess reserves meant that this increased availability of excess reserves did not lead after 2008 to much faster deposit growth and a much larger stock of money.

So it is not surprising that inflation has remained so moderate – indeed, lower than in any decade since the end of World War II. And it is also not surprising that quantitative easing has done so little to increase nominal spending and real economic activity.

This explanation seems highly dubious to me.

Econ 102 says that banks lend money to long-term risky projects. They choose to lend if the expected real rate of return from a risky project is greater than r + S, where r is the safe real rate of return, and S is some required spread.

With IROR > T-bill rate (as now), the IROR is the safe asset. With IROR < T-bill rate, the T-bill rate is the safe asset.

The IROR is 0.25%. The T-bill rate is just over 0%. This means that the difference in the expected real rate of return between a world with an IROR and a world without an IROR is about 0.25%. In a world without an IROR, banks lend to any risky project with an expected real rate of return of S. In a world with an IROR, banks lend to any risky project with an expected real rate of return of S + 0.25%.

Therefore, what Feldstein is asserting is that there is an absolutely huge number of risky projects whose expected return is between S and S+0.25. He is asserting that if we lowered the safe rate by 0.25%, a huge panoply of projects would then become worth investing in, and a huge torrential flood of reserves would be released into the economy, boosting inflation and lowering unemployment in the process.

Does that seem reasonable? To me, that does not seem reasonable in the slightest. First of all, it is a priori dubious, because of the small numbers involved. Second, since S actually differs from bank to bank, depending on lots of different factors, it makes sense that if Feldstein were right, then some of the big banks would be lending like gangbusters and others wouldn't. Is this what we see? To my knowledge, it is not.

Therefore I conclude that the IROR is not the reason why QE has not translated into higher bank lending, higher inflation, and lower unemployment. The answer must lie elsewhere; it must be the case that either S is very high, or there are very few projects with decent expected rates of return, or maybe some sort of institutional constraint on the speed with which banks can ramp up lending. But that little 0.25% IROR can't be what's holding the economy back.

Update: Also, as Matt Rognlie emails to remind me, Japan didn't pay interest on reserves from 2001 to 2008. And Japanese bank lending went nowhere during that period despite a burst of QE. So that is another nail in the coffin of the IROR hypothesis. Always remember to look at Japan!

121 comments:

It's funny how this is just coming to light right now. I've been asking my econ 101 students this question for years now. We talk about the possibility of the effects on inflation but also discuss why the Fed started to pay IROR at about the same time they wanted to increase the overall money supply. It's a great discussion topic for students starting to learn how to think like economists but not sure if it's a topic Feldstein can really run with here. Thanks for the post.

I understood the IROR as another way for the government to recapitalize the banks which after all were forced to undergo "stress tests" not too long ago. It was a way to calm the panic. And it becomes another tool in the Fed's exit strategy as Feldstein mentions:

"The Fed could, in principle, limit inflationary lending by raising the interest rate on excess reserves or by using open-market operations to increase the short-term federal funds interest rate."

Why isn't there more lending? The banks aren't seeing demand for loans from entities with good credit and their lending standards are too high now for everyone else.

The primary objective of the IROR is to assist the Fed's exit strategy when normal lending resumes. Given the vast amount of reserves in the banking system, the Fed is worried that if banks resume lending it will not have time to reduce liquidity fast enough by using open-market operations, and therefore prevent inflation from rising. One option is to raise the IROR so as to slow-down the expansion of credit, thus buying itself time.

My understanding was that the sole monetary policy reason for IOR was concern about downward volatility in the target Fed funds rate. IOR is supposed to create a narrow channel system, with IOR as the floor rate and the discount rate as the ceiling. In theory, the FF rate should never dip below the IOR floor since no one will lend reserves out at a rate lower than what they can receive by holding them. Similarly, the FF rate should never exceed the discount rate, since no one will borrow reserves from a bank at a rate higher than the price they would pay by borrowing from the Fed directly.

In practice the FF rate has dipped below the IOR rate, which as far as I can tell still seems to be something of a disputed mystery, but is apparently due to the fact that there are non-depository institutions that are government sponsored and participate in the Fed funds market, but are not eligible to earn interest on reserves. They will lend at a rate lower than the IOR rate.

Dan, I don't think the Fed's concern was the volatility of the FF rate. Historically, the Fed has been very good at defending the targeted FF rate with open market operations. As far as the FF rate dropping below the IROR, most likely it is because some financial institutions are not eligible to receive interest on their reserves, so they are willing to accept a lower interest rate in the federal funds market.

Do you remember when I said what Feldstein's saying here that the Fed would raise the IOER as part of its exit strategy and you said I was wrong? And then you wouldn't own up to the fact? That's dialogue on the Internet.

Don't know how to be much plainer, Peter, but here goes. When the Fed announced it would pay interest on reserves, Bernanke alluded to the fact that they had experienced difficulty keeping the interbank lending rate from falling to zero, below the rate they had targeted. By paying some rate of interest on reserves that banks hold in their reserve accounts, one should be able to establish a floor and support the interbank rate above that floor, since the assumption is no bank will lend money to other banks a rate lower than they can receive just by holding the money in their reserve account.

But that turned out not to work precisely as planned. The interbank rate routinely fell below they .25% rate of interest on reserves. (For example, yesterday the volume-weighted average was .09%) The reason for that appears to be that there are some institutions that have access to the Fed funds market, but are not eligible to receive interest on reserves. Since they earn no interest at all on their reserve holdings, they are then willing to lend at a positive rate of interest lower than the .25% rate of interest the Fed pays on reserves.

You are right that the Fed has announced that it will raise the rate of interest on reserves as part of its exit strategy. It has also announced other tools. Raising the rate of interest on reserves can't in itself constitute the exit strategy, since paying higher interest on reserves results in a net addition of reserves to the banking system. Raising the rate will indeed raise the Fed funds rate, but the Fed funds rate is not that significant in a situation in which banks are carrying massive quantities of excess reserves. For example, if a bank already possesses sufficient reserves to double their lending without borrowing any additional reserves, and if the Fed increases the amount of money it is adding to reserve accounts as a result of interest payments, then the bank has no pressing concern about how much it costs to borrow additional reserves.

So the Fed will have to use other tools to drain reserves from reserve accounts, including offering term lending facilities (interest-bearing savings accounts) to get banks to remove money from their reserve balance and put it on ice. Also, much of the reserve drain will be accomplished just letting the securities the Fed has purchased run off its balance sheet.

CA, the FR Bank of New York offered the following explanation on their website in an FAQ about interest on reserves:

3. Why is the payment of interest on reserve balances, and on excess balances in particular, especially important under current conditions?

Recently the Desk has encountered difficulty achieving the operating target for the federal funds rate set by the FOMC, because the expansion of the Federal Reserve’s various liquidity facilities has caused a large increase in excess balances. The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Paying interest on excess reserves will better enable the Desk to achieve the target for the federal funds rate, even if further use of Federal Reserve liquidity facilities, such as the recently announced increases in the amounts being offered through the Term Auction Facility, results in higher levels of excess balances.

"Raising the rate of interest on reserves can't in itself constitute the exit strategy,"

No one said that.

"So the Fed will have to use other tools to *drain* reserves "

The exit strategy is a strategy to prevent the reserves from entering the economy to quickly. Remember, you warned us how bad inflation would be for the common worker?

"For example, if a bank already possesses sufficient reserves to double their lending without borrowing any additional reserves, and if the Fed increases the amount of money it is adding to reserve accounts as a result of interest payments, then the bank has no pressing concern about how much it costs to borrow additional reserves."

If, if, if ... if the banks can make money on the reserves by loaning them out, they will, and the reserves will *drain.*

With relatively small exceptions, reserves don't "enter the economy". They function as the clearing balances for interbank payments. If bank lending increases, reserve balances don't get drained; they don't shrink. They just move more rapidly from bank to bank. So long as those reserves are significantly in excess of the net reserve requirement based on the current level of deposits, then banks can increase their lending in the aggregate without incurring a net cost for additional funds. So if the Fed gets to the point in some optimistic future where it wants to slow down the pace of lending, it will have to take steps to drain reserves from reserve accounts.

Dan--see my comment farther down for the model citations (from the New York Fed) that should make this clear. I really don't see how you could be plainer either, but maybe that will help. Like I said, this is complicated, but not that hard. The short answer: reserve levels are (mostly) irrelevant for bank lending and any connection depends on frictions in the system. Despite what everyone "knows".

dan @ 2.12your first answer was not at all clear and full of jargon.If you had to explain this to you brother in law the plumber, what would you say ?I highly doubt words like "channel" would figureyr 2.12 is much, much better

hello noah. good catch again!But I am quite surpised your rebutall of this feldstein article is so soft! I am sure you well know that banks dont need these excess reserves to lend. So the relationship between excess reserves and lending is very weak , except for the 'animal spirits' case.Inflation may well come if strong gdp growth was created through all the channels attached to QE (expectations of lower short term rates because of fed balance sheet size and possible losses, wealth effect, portfolio effects, lower long term rates for housing and investments, etc...)And if the economy was not operating so below potential, so no bottle necks now!And don't forget that QE substracts income from the private sector (coupons remitted to the treasury), and that woudl on the contrary be anaklog to a tax, so deflationnary, as long as the treasury does not use this remitted money to deficit spend...

Sumner also places a lot of importances on the deflationary impact of IOR. He called it a "confession of deflationary intent", discouraging investment on the expectation that growth will be throttled, which becomes self fulfilling as projects are not undertaken.

Noah, your analysis uses Econ 101, but you should use Finance 101 logic. Discount rates are not firm specific, they are project specific. IROR=Treasury+0.25% represents an arbitrage opportunity.Let's consider a 1 period model. A bank has $1 to invest and must decide between reserves and some project i. The bank's decision rule is to maximize firm value (NPV of projects). Given two options, reserves and project i, the bank will invest in i if an only if the following holds:1*(1+IRR_i)/(1+S_i)>1*(1+IROR)/(1+TBill)Log-linearizing, the condition becomes:IRR_i-S_i>0.25%So the bank must be able to earn "rent" of 0.25% on a project to prefer it over reserves. In a competitive banking environment, this might be a rare thing. P.S. I don't think Feldstein's argument is new. We had this discussion two years ago at the lunch table.

Not correct. This seems to assume that the TBill rate is a rate at which the bank can borrow. But neither is. The bank does not borrow at the TBill rate, it lends. It also can lend at the IROR rate.

Note that if the bank could borrow at the TBill rate and lend at IROR, it would make infinite riskless profits doing this, since they have the same state-contingent payouts. That would be true arbitrage.

So anyway this is not the kind of calculation you want to be doing here, since a bank does not arbitrage between the TBill rate and the IROR.

You've missed FinFud's point, which is that there is no "rate at which the bank borrows"; that rate is endogenous, determined by the riskiness of its investments. See the latest of the Hull and White papers on FVA for a very lucid explanation.

As long as the banks can make a safe 0.25%, they have no need to lend to anyone, given that their holdings are large enough to be multimillion dollar executive salaries. Why take the risk?

Most of the businesses I know who need funds go to banks. They go to angel investors, kickstarter like web sites or their own customers who will be repaid in kind at a discount. Our current banking model is obsolete. We should have let every last one of them fail, made good on the depositors up to some level and let the free market build new institutions.

Martin Feldstein wants to believe there is a recession or liquidity trap when that coudn't be further from the truth. There is inflation everywhere but in the cpi, and this is what the fed wants. QE is doing what is it supposed which is: 1. prop up asset prices like stocks and real estate. stocks are at historic highs and bay area real estate has surged 25% in just a single year2. raise cost of living to force consumers to spend more which goes into GDP. this is also working as evidenced by the plunge in the personal savings rate since 2008. Gas, rent, tuition, insurance prices all going nuts partly due to QE.3. lower rates to make it easier to businesses to repurchase shares, conduct M&A

Monetarists get themselves confused by insisting on thinking in terms of quantity, when thinking in terms of interest rates gives the correct answer more simply.

For example, negative IOR would be inflationary only if the Fed did *not* literally print money. Because printing money establishes an interest rate floor (at 0%). But try telling a monetarist that money printing is (in this case) deflationary, and he'll give you a dirty look.

Using a model I've been working on for the past year or so, I have a potential answer to why QE hasn't resulted in more inflation:http://informationtransfereconomics.blogspot.com/2013/07/predicting-2020-with-information.htmlThe basic answer is that inflation is not really in the cards; the maximum possible inflation rate is about 2% (because the base is so large relative to GDP ... and fiscal stimulus is unlikely).

The model also shows that Japan would be in an almost constant deflationary state (given conventional monetary policies) per Noah's post awhile back:http://noahpinionblog.blogspot.com/2013/07/japan-and-liquidity-trap.htmlhttp://informationtransfereconomics.blogspot.com/2013/07/dotting-and-crossing.html

Maybe it is a silly toy model, but it does reduce to the basic quantity theory/Cambridge k model in the relevant parameter space (high inflation) ... so it is a minimally silly toy model.

We should be asking what banks and what depositers have given rise to the two trillion dollars in excess reserves. Somewhere there is a huge drain of money from the economy creating a form of "fiscal" drag. I suspect that the excess reserves represent primarily off shore US dollar deposits by American companies who do not want to pay taxes on repatriated profits. Those "off shore" profits themselves are largely the result of artificial transfer pricing schemes to avoid American and European taxes. It may be that the tax system is the appropriate way to get those funds back in circulation.

(I assume that the excess reserves form a part of the total US government borrowing. If not then where do the reserves "go".)

Noah, Cochrane comes to much the same conclusion as you but for different reasons:http://johnhcochrane.blogspot.com.es/2013/06/monetary-policy-puzzle.html

"Suppose the Fed raises interest rates but does not raise the rate on reserves? Now, [don't] banks have an incentive to lend [reserves] out instead of sitting on them[?...] The answer is no, I think, but revealing about what the Fed can and cannot do."

Switch this to "Suppose the Fed holds interest rates constant but reduces the rate on reserves? Now, don't banks have an incentive to lend reserves out instead of sitting on them?", roughly the question you are asking in this post, and the logic of his argument remains the same.

How in the world can banks "lend out reserves"??? Everybody writes that but it doesn't make sense (unless the native english speaking people think of something else than I do)!

A bank cannot lend out reserves. It can originate a new loan, for which it needs more reserves through the reserves requirenment, or it can convert the reserves to physical cash and store it in a vault (or drop it from a helicopter). But the last point does not make any sense, since it incures costs for a bank to store it. So where shall the direct inflationary process in having excess reserves come from? It just sits in the accounts of commercial banks (yes there might be indirect effects through a better looking capital structure of the bank and therefore a better possible ability to extend credit. But as we have seen, in balance sheet recessions banks cannot find enough willing borrowers and borrowers cannot find willing lenders. So credit creation remains anemic unrelated to the amount of excess reserves.) And this is not a matter of paying IROR or not. Reserves are basically stuck in the interbank market no matter what. They always come back to a commercial bank. The interbank market is a closed system. The monetary base doesn't change unless the central bank intervenes (OMOs,...). It is like a hot potatoe effect. One bank extends a credit, and gets the required reserves from another bank which has them in excess. And so the sum of reserves stays the same.

So please tell me, how should reserve be lend out? I cannot go to a bank and tell them to lend me the reserves for one month. I can get a credit for which the bank has to fulfill underlying reserve requirenments, but the public cannot obtain central bank reserves in any way!

I think you are quite right Noah. But I have a question: A reserve balance is not like a Treasury because it has no fixed rate of interest. The Fed can adjust the rate of IOR at any time, at which time one's existing balance begins to earn higher interest. Also, a reserve balance doesn't mature with a repayment of principle, but can be held indefinitely. So there is a speculative element in acquiring and holding a reserve balance that doesn't exist (or at least is of a different kind) in the case of Treasuries.

Could that mean that banks have an incentive to stockpile reserves now in anticipation of a higher rate of interest on reserves in the future? After all, the Fed has signaled that part of its exit strategy will include raising the rate of interest on reserves to boost the Fed funds rate. When that happens, those who are already holding large excess reserves will make lots of money. Those who are not will rush to borrow them on the way up which will drive the Fed fund rate up quickly to the new target. They will not do as well as the reserve Noahs (forgive the pun) who didn't have their reserve account ark ready to go.

Could that mean that banks have an incentive to stockpile reserves now in anticipation of a higher rate of interest on reserves in the future? After all, the Fed has signaled that part of its exit strategy will include raising the rate of interest on reserves to boost the Fed funds rate. When that happens, those who are already holding large excess reserves will make lots of money.

Actually no, they will not. A higher interest rate does not cause a capital gain.

Could you explain further, Noah? As I understand it, the IOR payments are made 15 days after the end of each bank's one-week or two-week maintenance period. So if a bank has a reserve balance of any size, and the Fed raises the IOR rate, then starting 15 days after the end of the current maintenance period, the bank will immediately begin receiving larger interest payments on its one-week or two-week schedule. It's not like a Treasury where the bank has to go out and purchase a new asset at the higher rate.

Sure. Suppose the IROR rises. Nothing happens immediately; banks simply start receiving a higher interest rate. It will presumably then make sense to liquidate a few projects and keep the proceeds as reserves. The bank can do this at its leisure, and start reaping the higher IROR as soon as it liquidates those projects. It does not reap a big one-time capital gain by having a bunch of reserves at the exact time the IROR is raised.

In other words, it makes no sense to keep all that money sitting around in reserves for years and years, just in anticipation of an interest rate hike.

Agreed. I'm agreeing that the current low, positive rate of IOR on reserves is not what is inducing banks to hold reserves and that the same behavior would be observed at a 0% rate. What I'm intrigued about is the effect on behavior due to the fact that the banks all know that the rate is going to rise significantly in the not too distant future as part of the exit strategy. The speculation is only about the timing and exact amount of the increase. But at some point the Fed will announce, "We're raising the rate of IOR to 2% (or whatever)", and as a result the Fed funds rate will immediately jump to about 2%. Market forces will then reduce the resale prices of fixed-rate securities and other assets by some comparable amount since the change in IOR increases the value of reserve holdings, and thus increases the amount of assets one needs to surrender to get those reserve holdings. People who already have reserves will get increased profits from them, while those who then seek to acquire more reserves will have to pay a higher price in terms of the assets they trade for the reserves.

It's like a market in which there are only two kinds of securities: bonds paying a fixed rate and perpetuities paying a variable rate. What is the effect on such a market if everyone knows that the perpetuities are at already at their bottom rate (doesn't matter if the bottom is 0%, .25% or 10%) and that the rate will be reset at a higher rate in the near future? You're the finance guy. I don't understand these things very well, so I am just posing this as a kind of pure decision problem.

FWIW, the whole picture of banks "lending out" their reserves is a bit flawed from the aggregate point of view. Most borrowers hold most of their money in electronic form. If bank deposit balances rose dramatically as a result of increased lending, we would only see a much smaller drain of reserves into public hands as people withdrew a little bit more walking around cash. For the most part the reserves would stay where they are. As people spend, banks make interbank payments and the reserves just move from one bank account to another account. So people are looking at the wrong thing if they are looking at the absolute sizes of reserve balances and wonder why they are not shrinking. However, ifd lending increases, some portion of those reserves will be reclassified from "excess" to "required" as aggregate deposit balances grow.

I completely agree with your honing in on comparing expected rates of return, and find Feldstein's framework dubious as well. However, to solely isolate the theoretical impact of IROR on bank lending, wouldn't it be best to compare two worlds where everything is the same, except the existence of IROR, if possible? If it is possible, shouldn't we be assuming that the safe real rate of return is the same in both worlds?

Where I'm going with this is that, at the end of the day, if IROR vs. no IROR doesn't change the safe rate, then, using your framework, which I agree with, IROR matters even less than what you've said here.

So the key question to start with is - in a simple model - why would the introduction of IROR all of the sudden change the real safe rate? In a simple model, before the existence of IROR, let’s assume US govt bonds are truly risk free and thus set the benchmark for the risk free rate. And so, if you introduce IROR, reserves, at best, cannot become any safer than govt bonds, and thus the rates of return between these two assets really shouldn't differ (in our simple model).

Now let's say that for whatever reason, with the introduction of IROR, reserves become safer than govt bonds. Well, their return should be lower than govt bonds, no? However, in your example, and in the real world, they're higher than some govt bonds. So more complex things must be going on in the real world that we're not adequately describing and controlling for in this simple example – e.g., different risk and liquidity profiles, certain Fed interventions, etc. So I'd say, before we can adequately control for all that stuff, it may be worthwhile to consider the simpler model. Maybe?

"IROR is not the reason why QE has not translated into higher bank lending"

Au contraire. As the growth of excess reserve balances grew pari passu with POMOs, ergo, all the purchases were transacted (ownership transferred), with the CBs (& not the NBs). Screw your head on straight. The IOeR policy incentizes the system to outbid the non-bank public for "specials" (the SB's insurance collateral). That in turn induces dis-intermediation (where the size of the NBs shrink, but the size of the CB system remains unaffected).

2nd verse, same as the 1st. The CBs have the FDIC. The NBs use "specials".

The CBs pay for what they already own. The NBs are the CB's customers. The CBs could continue to lend even if the non-bank public ceased to save altogether. The NBs do not (indeed cannot), compete with the CBs. And money (savings), flowing thru the NBs never leaves the CB system.

Net changes in Reserve Bank credit (since the Treasury-Reserve Accord of 1951) are determined by the policy actions of the Federal Reserve, not the savings practices of the public.

But Bernanke acts as if the CBs are intermediaries: “The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which IMPOSE COSTS and DISTORTIONS on the banking system”.

Never are the CBs intermediaries in the savings-investment process. From a system’s viewpoint, CBs, as contrasted to NBs: never loan out, & can’t loan out, existing deposits (saved or otherwise) including transaction deposits, or time deposits, or the owner’s equity, or any liability item.

When CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the creation of an equal volume of new money – demand deposits — somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.

Reserves & the money stock are endogenous & impounded; unless currency is hoarded (we have a managed currency – not a fiat one).

Whereas dis-intermediation hasn’t been predicated on interest rates for the CB system since right before Roosevelt’s “banking holiday” in 1933, dis-intermediation for the NBs today is predicated on the remuneration rate on excess reserves. It’s the 1966 S&L crisis redux.

I.e., lending by the CBs is inflationary (expands both the volume & directly effects the velocity of money). But lending by the NBs is non-inflationary (effects only the velocity of monetary/voluntary savings) - ceteris paribus.

Whether savings are used or unused (S may or may not = I), depending upon where they are held (by the CBs or the NBs). And unspent savings (non-use) represent a leakage in National Income Accounting.

Bernanke’s exit strategy testimony in 2/10/10 footnoted:“The Federal Reserve invoked Section 13(3) on two occasions during the 1960s to establish lending facilities for savings associations; however, no credit was extended through either facility”

Just as in 1966 S&L crisis, Bernanke fails to understand the difference between money & liquid assets. In 1966 the Fed turned the economy around by getting the CBs out of the savings business (reversed Reg Q ceilings).

This course of action did not reduce the size of the CB system, the volume of earnings assets held by the CB system, the income received by the CB system, nor the opportunities of the CBs to make safe & profitable loans. To the contrary.

By promoting the welfare & health of the most important lending sector of the economy (the NBs), the health & vitality of the whole national economy improved. The aggregate demand for loan funds expanded, the volume of CB “bankable” loans grew, & so did the CB system.

As the growth of excess reserve balances grew pari passu with POMOs (& not the money stock), ergo, all the FRB-NY's purchases were transacted or netted (ownership transferred), with the CBs (& not the NBs).

(#1) Transactions between the Reserve banks & the commercial banks directly affect the volume of bank reserves without bringing about any change in the money supply. The “trading desk” “credits the account of the clearing bank used by the primary dealer from whom the security is purchased”. This alteration in the assets of the commercial banks (the banks’ IORs), increases - by exactly the amount the PD’s government securities portfolio was decreased.

The IOeR policy incentivizes the system to outbid the non-bank public for "specials" (the SB's insurance collateral). That in turn induces dis-intermediation (where the size of the NBs shrink, but the size of the CB system remains unaffected).

Think how the CBs initially arbitraged between buying [BORROWING] fed funds or repos from the GSEs (General Collateral), & the Fed's IOeR rate (before the FDIC asset-based premium was assessed on all tier 1 assets - including excess reserves).

Barclays -if I remember: "as the remuneration rate "was the highest overnight front-end rate in the market. For institutions with the ability to deposit cash at the Federal Reserve, the IOER level was a boon. These institutions could [borrow] cash, in say, repo or fed funds, and deposit the proceeds at the Fed to earn the spread."

Similiarily, now the CBs can [BUY] suppressed gov't securities from the NBs & then sell them to Simon Potter, Manager, System Open Market Account (at a better spread than could be obtained from the carry on a risk free arbitrage). It's a self-reinforcing cycle. Excess reserves & treasuries aren't perfect subsitutes.

Prior to 5/9/2013 (where the 2 yr was @ .22%), the CBs could buy (& resell to the Fed) everything shorter than 2 years out on the yield curve. This forced money market rates to have negative yields.

The IOeR policy inverts the short-end segment of the yield curve. You need to study what happened in the 1966 S&L crisis. If you can't debunk "Requiem for Regulation Q: What It Did and Why It Passed Away" by Alton Gilbert (FRB-STL), you don't understand economics.

http://bit.ly/MgHSvZ

What appears to be common sense is uncommon understanding. To wit - Lenin: “The process engages all the hidden forces of economic law on the side of destruction, & does it in a manner which not one man in a million is able to diagnose”.

Bernanke thinks reserves are a "tax". A brief “run down” will indicate just how costless, indeed how profitable – to the participants, is the creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits. The U.S. Treasury recaptures about 98% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers complained that they didn't earn any interest on their balances in the Federal Reserve Banks.

On the basis of these newly acquired free reserves, the commercial banks created a multiple volume of credit & money. And, through this money, they acquired a concomitant volume of additional earnings assets. How much was this multiple expansion of money, credit, & bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system acquired about 93 (c. 2006), dollars in earning assets through credit creation.

You must have limited functionality on your site. Sumner deletes whatever he doesn't want to deal with.

(1) From 1942 until 2008 the banks minimized their non-earning assets. With excess cash, they'd buy gov'ts from the non-banks & expand the money stock. After the IOeR policy, the CBs reversed the flow & traded any gov'ts for IBDDs. I.e., they pillage safe-assets from the NBs (as they can outbid the NBs via arbitrage with the remuneration rate), & re-stock their shelves.

(2) DDs are simultaneously created in conjunction with a bank's investments (just as with loans). The CB's best customer is the U.S. Treasury (it's as creditworthy as any loan applicant). But because the Fed flattened the yield curve (LSAPs, Operation Twists, etc.), thereby reducing net interest rate margins, it priced small businesses & consumers out of any new financing opportunities under c. $30,000 (e.g., "long-term assets were just 17 per cent of banks' portfolios; now they are 28 per cent").

" 'small' businesses make up a big chunk of the U.S. economy – 49.2% of private sector employment and 46% of private-sector GDP"

See also:

"Low Inflation in a World of Securitization" FRB-STL

"U.S. credit conditions may not drastically improve until sources of market funding start to recover. The Bank of England has moved away from asset purchases toward incentivized lending schemes that loan high-quality collateral (gilts) to banks, which can then be used to obtain cheap funding in repo markets. Given the U.S.’s reliance on market-based credit, similar policies to subsidize repo borrowing may have more impact than continuing to increase bank reserves"

From the period 10/1/2008 until the present: 87% of Reserve Bank Credit (“manna from Heaven”), became excess reserves. But required reserves grew by only 5.45% (& required reserves are based on transaction type deposit classifications 30 days prior – i.e., our "means-of-payment" money, where 93-96% of all demand drafts clear thru). That corresponds to a 5.67% increase in Commercial Bank credit (where from the system’s standpoint, loans=deposits).

The Fed’s “open market power” has been emasculated by the IOeR policy. As of Oct. 9 2008, the FRB-NY’s “trading desks” POMOs can be likened to “pushing on a string”. And QE stimulus is becoming ever less effective. Given a dollar’s worth of bond purchases in 7/2009, .75% were converted to excess reserves. But today given a dollar’s worth of bond purchases in May 2013, 1.37% are converted to excess reserves. I.e., 83% more IBDDs are created today by the Fed than 5 years earlier. Is QE becoming contractionary?

Noah! What was your purpose in dragging Feldstein's article into public view -- and responding?

Did you understand yourself to be performing a tiresome but necessary public service? Did you recognize a fellow-traveler but one who, if not corrected, might leave a poor impression of the sect?

Why did you respond empirically rather than just saying "excess reserves don't lead to excess deposits (that is, growth in the money supply) caused by overlending since such lending is not dependent upon the quantity of reserves in the banking system"?

Noah! What was your purpose in dragging Feldstein's article into public view -- and responding?

Improving the public's understanding of the macroeconomy, in some tiny way!

Why did you respond empirically rather than just saying "excess reserves don't lead to excess deposits (that is, growth in the money supply) caused by overlending since such lending is not dependent upon the quantity of reserves in the banking system"?

First of all, my response was not entirely empirical, it was partly theoretical at all.

Second of all, what you're saying doesn't demonstrate my point, even if it were true.

Frankly, I am not seeing the recovery "struggle" much at all. The Economy looks to be nearing the latter stages of the recovery. To much government data bias.............those departments have been slashed for years. They can't get it right until revisions and those revisions can take years. They need more manpower, but aren't going to get if from these goons.

This will eventually steepen the curve and push lending higher in the coming 18 months completing the recovery. Following the nominal spending path, yup, 18 months.

The economy is booming, especially in the private sector. Stores are packed with people. Consumers can't spend fast enough. The public sector, with the exception of defense, has been in decline for years and no one seems to care too much. The curve won't steepen much though.

They're both safe assets in the sense that they should be protected against default, although the Republicans are doing their darndest to make the T-bill unsafe.

So assuming they are both equally safe, then the only risk involves inflation. So you wan't to hold the safe asset that pays the highest return.

But all this means is that investors have decided there's no return on investment to be seen for increasing capacity via business investment, because demand is not increasing fast enough to absorb that capacity.

These guys can't possibly believe what they say. Their arguments are so contrived to be transparent, or perhaps they really don't understand anything about our monetary system. It is hard to say which it really is.

What's really happening is that they're trying to divert attention with monetary propaganda while the Republican's try to default the government. If they can do that, it is ripe for a hostile takeover.

Fascist takeover? Yes, pretty much. Not hard to do at all. The corporations are much richer than the government at this point. Trillions to spend, no place to put it.

Are you trying to make a case for redistribution of wealth, because they tried that in China and it resulted in the deaths of millions of people. Corporations shouldn't feel forced to waste money hiring overpaid employees if they don't want to. We're becoming a temp nation, and this is good because temp workers provide more economic value than overpaid regular employees. Oh, and then you have Obamacare casting pall of uncertainty for businesses that would otherwise want hire.

lol, it also happened in America with the New Deal and SS. GDP per capita rocketed.......

Think China's "communist" party as the capitalists. They "owned" say a farm and thus the "workers". Then the 'capitalist' would "distribute" as he saw fit..........see the problem? Ownership has always been the issue. If the workers can't own it in any form, thus they will not get the redistributive effects.

They still do this today. Most of the "deaths" sure didn't stop them breeding like rabbits.

With apologies, I think both you and Feldstein (and Cochrane, too) have got it backward. In actuality, the Fed began to pay interest on excess reserves BECAUSE reserves had increased, not the other way around...in many ways to preserve the functioning of other short-term liquidity facilities. This is surprisingly more tricky than most economists or finance folks think...and it all stems from a failure to realize that the money multiplier (here flashback to that dreary t-account in any money and banking textbook) is a poor descriptor of the systemic role of the monetary base in a modern banking system. Rather than go too deep into this, I'll let the folks who do it for a living go at it:

http://www.newyorkfed.org/research/staff_reports/sr497.pdf

or the easier summary (with T-accounts!) here:

http://www.newyorkfed.org/research/current_issues/ci15-8.pdf

"We …find that, absent any frictions, lending is unaffected by the amount of reserves in the banking system. The key determinant of bank lending is the difference between the return on loans and the opportunity cost of making a loan. We show that this difference does not depend on the quantity of reserves."

Feldstein (and to a much lesser extent, you) get this wrong when they say the rate "induced" banks to hold reserves. The reserves are a sideshow, and IROR is a policy tool to preserve the functioning of important short-term money markets which do very unpleasant things at the ZLB.

A broader lesson here is that banking, especially systemic banking issues and monetary policy in a realistic (meaning with liquidity effects and short-term funding markets) economy, is very tricky and often counter-intuitive. And most of what we "know" and teach about money and banking is fundamentally wrong.

Feldstein's statement can be shown false very simply. Reserves (excess or not) are an entry in the Fed's ledger. They can only be lent to other entities with Fed accounts - roughly speaking, only banks. Excess reserves are not lent out to retail/commercial sector because they simply can't - reserves only exist in the Fed system. There are two forms of linkage between the Fed ledger and bank ledgers. First is physical cash which can literally "move", but which is so small in quantity it's irrelevant - plus it's unlikely that Chase will lend out 500k in physical cash. Second is through reserve requirement constraints on lending - but with so much excess reserves, this is not a constraint. The entire statement was misinformed from the start.

False. From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, & probably its legal reserves (gratis – not a tax), & thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other CBs (e.g., an outflow of cash & due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit.

Thus IBDDs (excess reserves) are indeed “lent” from the standpoint of an individual bank (have reserve velocity) but are not destroyed from a system’s perspective (unless Federal Reserve Bank credit on the BOG’s balance sheet changes).

I.e., CBs need clearing balances to lend (from an individual bank’s perspective), but these “reserves” are either re-deposited within the same institution, or shifted to (clear thru) other CBs (reflecting the distribution of reserves from the system’s perspective). I.e., they are either derivative or primary inter-bank demand deposits (IBDDs) to member banks, but just a change in the composition of IBDDs for the system.

Even with CB credit expansion, total reserves remain the same, but their form may change if excess, or “precautionary” (liquidity) reserves need to be converted to legally “required” reserves (though since c. 1995, for our FRB system, reserves are no longer binding).

So excess reserves may be depleted (if not offset by the “trading desk”), as “factors that affect reserve balances change” (as currency is issued or as System Open Market Account securities are sold or “run off”, etc).

Fractional reserve (or prudential reserve) banking is a function of the clearing velocity of centralized bank deposits (based on interbank payments & settlements, i.e., liquidity backstops). Money creation is not a function of the volume of CB deposits. I.e., for the CB system, the whole is not the sum of its parts.

I was unaware that people still had some problems with why QE is not really working. And this appeal to reserves is indeed very weak. I am with the previous commentators who said "Hold on, didn't we know that for the past several years?"

My own take on the subject: http://theredbanker.blogspot.com/2013/03/inflation-or-deflation-refreshing-macro.html

Relevant quote: "Now, bank reserves are not yet 'money'. For it to become 'money', banks need to lend. In our present circumstances, this is not happening, partly because severely burned banks have tighten their lending standards and partly because severely burned customers are in no hurry to take on more debt".

I could add that, as someone else noticed, good corporations are flushed with cash and why would you want to lend to the others?

As long as AD is weak and forecasted to remain weak, why would a company want to invest?

I generally agree with your conclusion, but out of my sense of economic conditions, not because your model works. You fail to take into account the feedback loops involved in credit expansion. If credit were expanding more quickly many more projects could appear more viable. The impact of IOR on inflation is very difficult to estimate. But my sense is it's currently fairly small.

Going back to the crisis there was a time when banks were holding on to reserves irrespective of any interest earned on it, with the only concern one of provisioning against a sudden default in the system (think of it as a corner solution).

The point of paying interest now is that as soon as the banking system returns to an interior equilibrium, the Fed will find itself with a policy instrument with traction, with which it can affect the banking sector's tradeoff between holding on to reserves and lending out.

Thus I think that Feldstein's argument makes sense near an interior equilibrium, towards which we may possibly be converging these days. But it makes absolutely no sense back when Feldstein and others were predicting hyperinflation, because the system was at a corner in which the marginal return on investment mattered not at all. Anyone who studies recessions knows this to be the case, but it was especially severely the case back in 2009, 2010, etc..

Joan Robinson said that one of the reasons why neoclassical economics stinks is that it works in logical time, not historical time. Reserves are provided later by the CBs (see Constancio) without questions asked, otherwise interbank interest rates would skyocket.

I've been wondering if lenders are constrained by underwriting capacity now that they're actually trying to underwrite loans. There may be plenty of projects that meet the lending requirements but it would take more work to prove that they do.

The low interest rates have extended great capacity to refinance to borrowers who already have good credit but I wonder if the people and businesses without a proven history are on the outside looking in.

I read in a textbook someplace that if you printed some new money and just hid it someplace it would not cause inflation. This is what Bernanke is doing. The Fed is making new money but keeping it in their building (probably just on a computer) so it does not cause inflation. The reason there is no inflation is just that simple.

If short term government bonds pay 0.25% or less then leaving money at the Fed is as rational as buying short term bonds. So far the Fed has been able to keep interest on short term bonds near zero. At some point this will all blow up.

Because the money isn't there. There has been nothing printed. Vincent represents the failure of blogging.

The real problem is the invester class through Q1 2013, they weren't investing much. Though, 2nd quarter, they upped their allocations. If this continues, then banks will find profitability lending again and thus ends the recovery.

The reason they are accepting 0.25% from the Fed for excess reserves is that the Fed has forced interest rates on the alternatives down below that. At some point interest rates will go up and they will choose to actually take their money out of the Fed. At that point the money might really be printed and will really cause inflation.

In the short term central banks can force interest rates down by making lots of new money and buying bonds. In the short term the low interest rates cause low velocity of money and you may not have much inflation. However, in the long term making lots of new money will cause inflation and higher interest rates. I think we are about to transition from short term to long term.

One more point. The idea that this is "holding the economy back" is wrong. When Bernanke's trick of making money but not letting it out of the building fails, the resulting inflation will destroy the economy not help it.

Easy. Japan had a "bank note rule" where they did not really increase the total currency. If you are buying bonds with money from other bonds that were paid off it does not cause inflation. They are ignoring that "bank note rule" now and I do expect different results now.

Earning interest on excess reserves is "risk free" so it should be compared to "risk free" alternatives.

The question of why risk alternatives can't win out over such low paying "risk free" alternatives is orthogonal to the argument that if new money has not yet left the Fed's building then of course it has not yet caused inflation.

The question of why risk alternatives can't win out over such low paying "risk free" alternatives is orthogonal to the argument that if new money has not yet left the Fed's building then of course it has not yet caused inflation.

The new money will leave the Fed's building when banks think they can make more than the Fed is paying them to keep it there. If interest rates keep going up and the Fed does not raise this 0.25% then it could happen soon.

How? What are the mechanics of it leaving? It could be as simple as a bank using some excess reserves to buy some 5 year Treasuries that were paying higher. It could be a bank takes out Federal Reserve Notes in an armored car. Probably some of both.

‘It is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.’

I don't understand this talk of "sequencing". The bank takes into account its borrowing costs when it makes loan decisions. The bank takes into account its loan opportunities when it makes borrowing decisions. These decisions do not happen all at once, but in a constant trickle and flow.

Maybe Constancio is talking metaphorically when he speaks of a temporal sequence. In reality no such sequencing is observed.

ECB, Monthly Bulletin (2012, May):The occurrence of significant excess central bank liquidity does not, in itself, necessarily imply an accelerated expansion of MFI credit to the private sector. If credit institutions were constrained in their capacity to lend by their holdings of central bank reserves, then the easing of this constraint would result mechanically in an increase in the supply of credit. The Eurosystem, however, as the monopoly supplier of central bank reserves in the euro area, always provides the banking system with the liquidity required to meet the aggregate reserve requirement. In fact, the ECB’s reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers

Adair Turner, Chairman of the FSA (Sept 2011)The banking system can thus create credit and create spending power – a reality not well captured by many apparently common sense descriptions of the functions which banks perform. Banks it is often said take deposits from savers (for instance households) and lend it to borrowers (for instance businesses) with the quality of this credit allocation process a key driver of allocative efficiency within the economy. But in fact they don’t just allocate pre-existing savings, collectively they create both credit and the deposit money which appears to finance that credit.

It's not practical for the banks as a whole to reduce their reserve accounts. The only way they can do that is by hording physical cash instead, and that would be silly and equivalent to having a large reserve account in a monetary sense anyway. Reserve accounts are the central bank liabilities that match its assets, and banks can only transfer money in their reserve accounts to other banks, or draw on them to issue physical cash which is the only other central bank liability that is available to banks. This is due to what the central bank does and how it operates. If the central bank buys stacks of bonds, banks will end up with matching large reserve accounts. It's just a mechanical/accounting thing and is irrelevant to inflation.

Before reserve banks tried QE, the total of all banks' reserve accounts were small because reserve banks weren't trying QE. Reserve banks normally keep a small balance in banks reserve accounts by buying small amounts of bonds. Reserve banks do this to enable daily fluctuations in bank transfers to be handled without the reserve accounts going negative.

Every reserve bank that has tried QE has had its commercial banks' reserve accounts become just as large as the size of the QE. By accounting, this has to happen because the reserve accounts are the liabilities incurred by the central bank when it buys bonds. Look at the balance sheets of the central banks. They are avaialble on a monthly basis on most central banks' web sites.

In practice, the central bank controls the size of the commercial banks' reserve accounts - not individually, but overall. Banks can individually change the size of their reserve accounts, but only by transferring their liabilities between banks, and this does not change the overall total of reserve accounts. There are theoretical things that banks might do to change this (eg. hording cash), but they are not practical.

The reserve bank of Zimbabwe seems to have stopped publishing its balance sheet in 2005, and even then there wasn't a sufficient breakdown of liabilities to determine what the size of the commerical banks' reserve accounts were. How do you know that the reserve accounts didn't grow just as large as the QE?

And anyway, a dictatorship with poor rule of law and probably inaccurate government accounting is hardly a good example of what happens in western countries.

The way I know is that in hyperinflation the central bank is making money and buying government bonds and the government is spending the money it gets from selling the bonds. So it is as if money is just being printed and spent. Much like what is really going on in Japan right now. Hyperinflation works the same for democracies and dictators, for East and West, with rule of law and without. Hyperinflation is an equal opportunity destruction.

But that is because the public loses faith in the currency and if it is fiat, then the government has to really (not just literally like in Japan, the USA,... today) print money and hand it out to the people, because they would otherwise reject the currency completely. Hyperinflation is a cognitive phenomenon, not merely an economic and has to be strictly separated from high hinflation.

The reason nobody buys government bonds during hyperinflation, except the central bank, is the value of the currency is dropping much faster than the interest payments can compensate for, so it is a crazy bad investment.

Vincent, you are correct in your description above about the government spending and the central bank buying bonds, but you need to follow the whole process through. Government spending consists of transfers from the government's reserve bank account to the accounts of the receivers of the government expenditure. These transfers happen by way of the commercial banks' reserve accounts, and the result in each transfer is that the commercial bank's reserve account increases by the same amount as the account of the receiver of each government transfer.

From the central bank's point of view their liabilities to the rest of the government have been transferred to a liability to the commercial bank. The commercial bank has received an asset (the reserve account increase), and a matching liability (the receiver's account increase). Neither bank has had any change in their net assets. The government financial assets have gone down, and the receiver's financial assets have gone up. The total of all bank's reserve accounts will have matched the total of government expenditure that was not funded out of bond sales - that is the QE.

Even by 2005 Zimbabwe was experiencing inflation at a rate of hundreds of percent, and had been for several years. The reserve bank balance sheets are consistent with what I have described above, and are inconsistent with what you describe. There isn't enough detail to explicitly identify the reserve accounts of the commercial banks, but the overall aggregates balance as they should.

After 2005 I can't find records. It isn't clear what happened. Maybe the numbers got too big for the fields in the data bases, maybe the accounting rules were not obeyed, there is a wide range of possibilities as to what happened. Without accurate records you can't draw any conclusions.

Like Weimar Germany, Zimbabwe printed physical paper money. In Zimbabwe they were printing $100 Trillion dollar notes, I have one. If they are printing physical paper money, "loaning it to the government", and the government is spending physical paper money, then it will not be in excess reserve accounts.

What source are you looking at that makes you think the new money was excess reserves?

As I said in my first comment, cash is the only other common way that banks can affect the size of their reserve accounts, and you are now giving an example of that. But, the reserve bank (or the treasury of the government) has to cooperate by producing the notes, so it still isn't really within the control of the commercial banks - at least not on a scale of trillions of dollars. And that was the point - the size of the sum of reserve accounts isn't within commercial banks' control.

I am looking at the Reserve Bank of Zimbabwe balance sheets up until 2005 from their web site. You may have a note from later than that, and as I say, after 2005 who knows what happned. There was another three years of hyperinflation after that. Possibly once the databases couldn't deal with the numbers any more they found it easier to make enourmous denomination notes rather than get software changes made.